ECONOMIC AFFAIRS: Unlocking the riddle of the global financial crisis

by Colin Teese

News Weekly, December 20, 2008

Two global financial strategists have shown that central banks control only 10 per cent of total global liquidity. The other 90 per cent is accounted for by derivatives and securitised debt, reports Colin Teese.

Understanding a financial crisis is not so difficult, if we look behind the immediate and obvious cause and don't allow ourselves to be sidetracked. We should ignore the self-declared experts. Mostly they don't understand the crisis themselves - especially if they are wearing ideological blinkers.

We need first to sort out our priorities. Short term, we might choose to look for immediate causes of the descent into chaos, but eventually we must look deeper for underlying fault lines.

For the immediate causes, a useful starting point might be a short 96-page paperback - not much more than a pamphlet really - entitled New Monetarism by David Roche and Bob McKee (London: Lulu Enterprises, paperback: 96 pages). Both authors have worked as global financial strategists.

Risk magnified

Roche and McKee accept that the recent financial meltdown was caused by banks no longer having the confidence to lend - either to each other or to customers. Interest rates rose making capital more costly. In that emerging climate, risk became at once more obvious and greatly magnified. The risk, suddenly, wasn't worth the candle.

But the authors demonstrate that banks have good cause to worry about liquidity - they are actually strapped for cash. Why? Because, in past times, the business or economic cycle controlled financial markets. Today the opposite is the case.

Under the old arrangements, central bank funds were deployed in such a way as to exercise control over the amount of credit created. The sum of those funds and the associated credit defined world liquidity, and the world's central banks were in control.

Not any more. New Monetarism illustrates what has changed with an inverted pyramid:

• At the bottom of the pyramid a tiny point represents the aggregated value of all central bank funds. This is called "power money".

• Above that is a segment called "broad money": this defines the credit created by central banks on top of their power money. Whereas once upon a time this combination was the money supply, today it accounts for only 10 per cent of it.

• The other 90 per cent - the topmost segment of the inverted pyramid - is accounted for by derivatives and securitised debt.

The world's central banks, which control little more than a tenth of total liquidity, are now small players. They no longer have any real influence over the creation of most credit - or indeed of monetary policy.

Central banks, especially in the English-speaking world, have been pretending otherwise - while the world money market was being transformed before their eyes.

The world's total gross domestic product (GDP) is about US$60 trillion. However, the phenomenon of "new monetarism" has generated world liquidity of about US$600 trillion. In other words, financial transactions are 10 times the magnitude of the real economy, as measured by actual output of goods and services.

Roche and McKee explain how this works. Creating all this credit makes money cheap. The flood of easy credit invades the investment market. It helps Chinese manufacturers inundate the world with cheap goods, thus keeping down inflation of prices of goods or services. However, the excess liquidity is channelled into financial markets, generating inflation in the price of assets - notably in real estate and shares.

Thus, for the last 20 years, the value of financial assets and property has risen faster than that of the underlying economy. And lower fluctuation in asset prices - in fact, they simply kept rising - encouraged banks to underestimate lending risk and businesses to take on more debt.

The bubbles this created in share prices, as well as in housing and commercial property, could not be slowly deflated, and so, inevitably, they burst, bringing about the collapse of the entire financial edifice around them. Liquidity and confidence, of both consumers and business, associated with the bubble economy also evaporated.

Western economies are trying to rescue themselves from these consequences. However, Roche and McKee's book helps us understand why the actions so far taken by governments are unlikely to succeed.

Let us therefore take a look at what the US government and financial authorities are doing - if only because this is where the epicentre of the crisis seems to rest.

After some fiddling with interest rates and other various instruments, the US Treasury and Federal Reserve bank together decided that bank liquidity was a problem. On this view, banks had lost confidence and were unwilling to lend, either to each other or to customers. Accordingly, the Treasury and Federal Reserve forced Congress to agree to a US$750 billion bail-out package to allow banks to get back into the business of lending.

This didn't work for a number of reasons. But above all, the trouble was with the diagnosis. Liquidity was a problem, but not for the reasons the Federal Reserve and Treasury thought. The major issue wasn't an unwillingness to lend, but a bank debt overhang amounting to US$460 trillion, as identified by Roche and McKee.

This massive sum, it will be recalled, was the difference between the cash and credit feeding the financial system from the world's central banks, and the amount of additional liquidity created by derivatives and securitised debt obligations.

Compared with the US banks' share of that $US460 trillion, the three-quarters of a trillion that Congress was persuaded to allocate for shoring up US banks was nowhere near enough. And, taken collectively, governments around the world were no better placed. Like it or not, the world's treasuries simply don't have the $US460 trillion needed to bail out the world banking system. Ultimately, then, bail-out is not an option.

(To understand what a trillion dollars actually means, think of it in terms of time. Assume that $1 = one second. This makes $1 million = two years, $1 billion = 2,000 years, and $1 trillion = two million years).

"Wildcard" debt

Then, remember that we are talking about what might be called a "wildcard" debt of $460 trillion. Why wildcard? Because banks don't really know how much of it they really owe. Mostly, it relates to debts they have sold on to other institutions; it does not show on their own loan books to be set against their capital base and reflected on balance sheets.

Some debts will have to come back onto the banks' loan books, but they don't know how much. It could easily be enough to swamp the capital bases of many banks. Is it any wonder they can't be persuaded to lend?

Australian banks, too, are caught up in this problem.

Most Western governments have guaranteed, to a greater or lesser extent, their domestic deposits. This has been done to prevent a run on banks, and, to that end, it has worked. Our government has gone further. For a fee, it has guaranteed offshore lenders to Australian banks, in an effort to ensure that investors don't take fright and withdraw the loans they have made to our banks. So far, this too seems to be working.

The important side-effects of guaranteeing depositors in this way should be noted in passing. What were previously private borrowings by banks have now become government-guaranteed debt.

This gives the lie to the frequent assurances from the previous government that our overseas debt didn't matter to the government because it was merely between private consenting individuals. Well, it matters now.

Also, since the government now guarantees the debt of our banks - local and foreign - the foreign debt is effectively nationalised. To safeguard its investment, our government will be obliged to oversee banking operations.

But, useful and necessary as these measures may be, they do not address the problem of overall bank indebtedness. That problem seems unfixable. Perhaps, in the end, the banks' massive debt overhang may have to be written off - quite how that might be done is not clear, and is beyond the scope of this article.

Meanwhile, we should re-direct the focus of our priorities from the financial sector towards what really matters - the real economy, and especially the domestic manufacturing sector.

This is particularly so for the English-speaking West which has been trapped in an economic ideological bind for the last 25 years. As a consequence, those economies have allowed their manufacturing sectors to decline.

What's happening is there for all to see. Starting with the United States, nation after nation in the West, including Australia, is sinking rapidly into deep recession.

The Rudd Government believes it has taken decisive action by encouraging spending. But that is no solution. The way our economy is structured means that more spending will simply suck in more imports.

We need to recognise that the financial crisis is reshaping the world economy. There is no alternative for us but to make the necessary adjustments. It is no longer reasonable to believe we will be able to continue buying most of the manufactured goods we want with money borrowed offshore, and not worry about how it gets paid back.

Like it or not, we will be forced to make a much greater proportion of the manufactured goods we consume, even if it costs more to do so. We once did so, and can do it again.

Rebuilding our diminished domestic manufacturing production won't be easy, but it can be done. We should start by forgetting about globalisation and free trade. Restarting our manufacturing industries will deliver us the best results.

World output (GDP) is about US$60 trillion; world exports are about US$10 trillion. Dollar for dollar, expanding domestic manufacturing gives us six times the benefit of exports - and we can decide how best to target it.

Our focus should be to rebuild our manufacturing sector on the back of much neglected infrastructure development - notably, in the fields of health, education, transport and water.

To do this properly, we will almost certainly need some kind of government-funded investment bank. And we must ensure that as much as possible of manufacturing for any projects is done here.

In that way, we will save on foreign exchange outlays and create a very large number of long-term, well-paid jobs for Australian workers, both skilled and unskilled.

The necessary rise in spending will follow, and this time it will be based on jobs created here in Australia.

- Colin Teese is a former deputy secretary of the Department of Trade.